ETF Trends
ETF Trends

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By Dana Anspach

With over 10,000 mutual funds, when you go to buy a mutual fund, where do you start?

Start by learning what NOT to do. You’ll keep more after tax income when you avoid these five mistakes when buying mutual funds.

Mistake #1 Chasing Past Performance

Pop finance magazines have to sell subscriptions and advertising – to do so they use headlines like “Top Ten Funds to Own This Year.” The editors and journalists do not know if these funds will make you money.

No one knows if these funds will make you money in the upcoming year. There are factors, however, that have been proven to deliver over time (and being on a top ten list is not one of them).

For example, Morningstar, a company that does research on mutual funds, notes that the single biggest predictor of top performing funds was not their own rating system of assigning stars, but the fund’s fees. Lower fees directly correlate with higher performing funds. Index funds have the lowest fees. Don’t buy high fee funds. Those fees are lining someone else’s pocket; not yours.

Mistake #2: Buying Funds With Embedded Capital Gains

Suppose you buy a mutual fund in October. In December that mutual fund sells a stock it has owned for ten years. A pro rata portion of that gain is then distributed to all current shareholders of the mutual fund. So now you are paying taxes on a gain that occurred within a fund that you have owned for only a short time. As a matter of fact, if the market has gone down, your shares may be worth less than what you paid for them, yet you will still be responsible for paying taxes on a portion of this capital gain.

Related: ETF vs. Mutual Fund: The Same, But (Very) Different

When buying mutual funds in a non retirement account, you can avoid embedded capital gains by buying tax managed funds, index funds or ETFs.

At the end of each year you can also harvest losses by realizing a capital loss for tax reasons by exchanging one mutual fund for another similar fund.

(Note: this mistake is only relevant for mutual funds that are purchased in a non-retirement account. Inside of retirement accounts like IRAs, 401(k)s, 403(b)s, and other company retirement plans, regardless of the transactions that occur within or between the investments in the plan, you pay no taxes until you withdraw funds.)

Mistake #3: Buying Many Similar Fund Strategies

Many people own eight to ten different mutual funds and think they are diversified, but when you look inside the mutual funds, all the funds own the same type of stock, or the same type of bond. This would be like sitting down to a well balanced meal of pork, beef and chicken.

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